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Bangladesh must not swallow the IMF’s bitter pill and should choose its own mix of tax and public expenditure policy, writes Anis Chowdhury

The recent decision of the interim government to expand the VAT net and hike VAT rates at the behest of the International Monetary Fund has justifiably attracted harsh criticisms from all quarters. This is the worst decision of the interim government since its inception following the overthrow of the autocratic regime of Sheikh Hasina and is hence bound to have serious political consequences.

Unfortunately, it is also handled very poorly. Almost everyone in the government is responding to the critics. Some of them have no expertise in tax matters. Designing a ‘good’ VAT system is an extremely complex matter. Various claims are made without any empirical study or supporting evidence. Worst, at times some responded dismissively.

If there were any rigorous study by either the National Bureau of Revenue or Bangladesh Bank or the Ministry of Finance, the findings should have been made public, and the response to various criticisms should have been based on it. Instead, the authority’s response has been chaotic with incoherent assertions.

Thus, one can easily conclude that the decision was made whimsically, either due to ideological reasons or under pressure from the IMF. Instead of succumbing to the IMF’s pressure, the authorities could have at least looked at the international evidence.

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Verdict on VAT

Ever since the IMF pushed VAT on developing countries to compensate for revenue loss from tariff cuts associated with trade liberalisation, it was met with various criticisms. Among the questions raised are:

Are the VATs that most developing countries already have as good as they could be in economic, equity, and administrative terms?

Are they really the efficient, simple revenue-raisers they are often purported to be?

Can every country administer VAT sufficiently well to make the introduction of the tax worthwhile?

Can VAT deal adequately with the novel issues arising from digital commerce?

Are they so inequitable that it may in some cases exacerbate social tensions and hence undermine the political equilibrium reflected in a country’s fiscal structure?

Does VAT provide a way to tap the informal sector or may it end up expanding the range of such activities?

Is VAT always the best way to respond to the revenue problems caused by trade liberalisation in many developing countries?

Must all ‘good’ VATs follow the same pattern?

Research within the IMF itself found that VAT failed to compensate for the revenue lost and concluded that scope to raise revenue ‘by simply raising standard VAT or GST rates is becoming limited’ (see ‘Revenue Mobilization in Developing Countries’, by the IMF’s Fiscal Affairs Department; and ‘Tax revenue and (or?) trade liberalization’, IMF Working Paper No. 05/112, by Thomas Baunsgaard and Michael Keen).

VAT is generally found to be regressive; it hurts the poor more — those at the bottom of the income scale are affected disproportionately. Of course, careful designing with exemptions and varying rates can minimise adverse impacts on the poor and common people, but such an exercise is extremely complex and difficult to administer.

The latest verdict on VAT can be found in the Journal of Economic Perspectives (Winter, 2024, pp 107-132), published by the American Economic Association. The key conclusion is that, in the real-world, VAT often falls far short of its theoretical ideal, especially due to the challenges of informality, compliance costs and weak administration prevalent in lower-income countries.

The key findings are that, although the VAT is intended as a broad-based tax on all firms, in practice VAT revenue is highly concentrated amongst a narrow group of firms. Furthermore, small firms are more disadvantaged relative to large firms. In lower-income countries, limited administrative capacity, the risk of fraud and the reluctance to forego revenue mean that firms have to wait months, if not years, to receive a VAT refund. Long refund delays have serious implications for businesses’ cash flows, especially for small and medium enterprises.

As part of an emerging literature, this article documented the difficulties of VAT in developing countries. However, this does not mean that VAT has to be abandoned or replaced altogether. Instead, governments should focus on reforms that make the VAT more efficient, given the policymaking constraints they face.

But there is no universal design that can be implemented everywhere all the time. In public policy, no one size fits all. What is right, or at least feasible, say in Chile, may not be suitable for Bangladesh.

Therefore, rigorous research is needed to answer the questions listed above. Such research is critical not only for fiscal stability but also for political consensus — essential for growth, development and democracy.

Of course, governments need revenues for development and essential expenditures. But revenue adequacy cannot be the only concern. In choosing the tax level, policymakers need to consider how it is chosen, how the taxes are imposed, and how the funds thus raised are used. Historical evidence suggests that it is critically important to establish, as clearly as possible, a linkage between expenditure and revenue decisions in the budgetary and political process.

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Wicksellian connection

Knut Wicksell developed the concept of ‘benefit taxes’ and argued over a century ago that allocative decisions in the public sector will be made efficiently only if they are financed efficiently. It broadly means taxes should be deliberately chosen to finance specific expenditures in the full knowledge of the allocative consequences of both expenditures and taxes.

Wicksell believed that even such ‘good’ taxes would really only be politically sustainable if the distribution of income and wealth accorded broadly with the politically acceptable ‘just’ distribution of income, which may be different in different countries.

Thus, the central question of tax policy is how to make the ‘Wicksellian connection’ operational so that ‘good’ decisions — ie, reflecting people’s preferences as closely as practically feasible — are made on both sides of the budget.

This is possible only when decisions are made in a participatory manner, characterised by accountability and transparency.

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Political economy of taxation

Thus, the design of tax policies is not just a technical matter that can be left to accountants or economists or bureaucrats. As with any public policy, taxation is a political economy issue. It is always and everywhere what has been called a ‘contested concept’. This is because some pay while some do not; some pay more whereas some pay less; some receive compensating services while some do not. Such contested matters are — and in democratic states, can be — resolved only through political channels.

History suggests that the need to secure an adequate degree of consensus from the taxed is one of the principal ways in which, over the centuries, democratic institutions have spread. Non-authoritarian government cannot survive for long without securing a certain degree of consent from the populace, not least in the area of taxation.

In fact, state legitimacy rests to a considerable extent on citizens’ ‘quasi-voluntary compliance’ with respect to taxation. To secure such compliance, tax systems must, in some sense, represent the basic values of at least a minimum supporting coalition of the population.

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Back to the Bangladesh case

Undoubtedly, Bangladesh needs to improve its fiscal situation — both revenue and expenditure. Bangladesh’s government expenditure-GDP ratio is around 13.4 per cent, and is forecast to rise to exceed 15 per cent by 2030.

Although Bangladesh’s government expenditure-GDP ratio is below the middle-income countries’ average of 23 per cent, it cannot be sustained with a tax-GDP ratio, which reached 7.3 per cent in August 2024. It is not only well below the developing countries’ average (around 15 per cent), but also significantly lower compared to neighbouring India’s 12 per cent, Nepal’s 17.5 per cent and Bhutan’s 12.3 per cent. A further concern is its decline during the past regime from around 10 per cent in 2010.

From the political economy perspective, the central problem of Bangladesh is clearly high and growing inequality. And the related governance problem is lack of accountability and transparency.

A Wicksellian ‘good’ tax system is critical to the solution of both problems. Therefore, VAT reform should be part of the reform of the entire fiscal system to improve progressivity with higher taxes for the rich and wealthy (on the revenue side) and pro-poor, pro-growth spending programmes (on the expenditure side). Thus, perhaps taxes should be categorised into various levies linked to spending programmes, such as for education, health, social security and local infrastructure.

Taxes more tightly linked to benefits are generally seen as fairer and hence likely to have political support. A tighter tax-benefits linkage may also help accountability and encourage compliance as taxpayers can see what is achieved with their taxes.

Much of Bangladesh’s problem is that it lacks an implicit social contract between the government and the general populace of the kind that is embedded in taxation and fiscal principles and practices in politically more stable democracies. Unfortunately, such principles generally do not become embedded either painlessly or quickly.

It is striking that the recent VAT decision has been made without adequate public consultations just to meet the IMF’s programme conditions. This is clearly not the way to build a democratic consensus in support of a higher level of fiscal equilibrium.

Tax and public expenditure reform is a political economy issue that should not be left to the IMF, especially when it lost its moral legitimacy by providing a lifeline to an illegitimate kleptocratic government that clung to power by brutally suppressing people’s democratic rights and allowing its cronies to plunder the nation’s wealth (see my earlier piece, ¶¶Òõ¾«Æ·, December 24, 2024).

Bangladesh must not swallow the IMF’s bitter pill and should choose its own mix of tax and public expenditure policy. This is crucial for building an implicit social contract, without which democracy cannot be consolidated.

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Anis Chowdhury is an emeritus professor, Western Sydney University, Australia. He held senior United Nations positions at the Department of Economic and Social Affairs and Economic and Social Commission for Asia and the Pacific.